Kieran McQuinn: EU must learn from 2007 policy mistakes

Nobody about on Grand Parade, Cork. Picture Dan Linehan

Kieran McQuinn

Sunday, March 29, 2020 - 04:30 PM

COVID-19 poses the single largest challenge to the Irish economy since the financial crisis.

The response of authorities both domestically and internationally to the spread of the virus, while absolutely necessary from a general health perspective, will result in millions of jobs being lost globally in the coming weeks and months and a sharp contraction in global economic activity.

The swiftness of the economic deterioration is unprecedented in modern times and in many respects exceeds that of the financial crisis.

Given the unprecedented uncertainty concerning the virus, we in the Economic and Social Research Institute (ESRI) have conducted a scenario analysis analysing the impact of the virus on the Irish economy.

Mainly through demand-side channels, we examine the impact of the current restrictions on economic life based on the assumption that the restrictions will remain for a period of 12 weeks.

Under such a scenario, the domestic economy would register a recession in this year with output contracting by over 7 per cent. This constitutes a significant reversal of the pre-COVID-19 related economic trends.

Crucially, this scenario assumes that economic activity both domestically and internationally begins to recover significantly in Q3 and Q4 of the present year. If this does not occur, then the results will be even more adverse for the domestic economy.

All sources of growth such as consumption, investment and exports are substantially impacted under the scenario. Under the scenario, the unemployment rate is set to increase significantly with the rate increasing from 4.8 per cent in February to 18 per cent in Q2 2020 before falling back to just under 11 per cent by the end of the year.

This speed of change in the fortunes of the domestic and international labour markets is unprecedented.

Consequently, there will be significant pressure on the Irish public finances. The combination of the extra expenditure on health and social welfare allied to the sharp decline in certain taxation revenues means a deficit of almost 4.5 per cent is now likely to occur in 2020 and could be higher.

Greater expenditure may still be required in order to meet this threat to public health.

While the most pressing policy concern at present is to introduce whatever measures are required to stem the spread of the virus, policies to stabilise the economic fallout are also critical from an economic and human perspective.

READ MORE

The overarching policy concern should be twofold: protecting household incomes and ensuring businesses can survive the pandemic period and remain viable in the aftermath.

While the financial crisis and the current situation are very different, one lesson from the previous period should guide policy choices now. It is clear that households and firms with high debt levels cut back on consumption, investment and employment.

If businesses, in particular, are to maintain employment and return to growth when the acute medical phase of the current crisis has abated, policies should be focused on helping these enterprises to manage their payments and cash flow without running up significant debt levels.

Policies by the financial sector to provide loan repayment holidays are welcome and provide households and firms breathing space, but more is required across a range of fixed payment items (such as rent, utilities, taxes and other charges) to help businesses with cashflow pressures.

On the fiscal front, the Government is already taking stimulatory action. While a further stimulus will be required at some stage, in the immediate future fiscal policy support should be specifically targeted towards income supports and measures to help firms remain viable.

At present, with Government policy actively seeking to discourage people from engaging in unnecessary human contact, households are effectively being constrained only to consume bare essentials such as basic groceries. This would lower the impact of a broad stimulus now as households would have few avenues to spend. However, when the public health phase of the crisis is over, more traditional fiscal policy levers should be engaged in an extensive and globally coordinated manner.

It is clear that sovereign governments across the Euro Area are set to substantially increase their levels of debt over the coming months and years in response to this crisis. In the domestic context for example, it may be necessary to increase the deficit beyond the 4.3 per cent estimated under the present scenario; governments must do all that is required to meet the healthcare demands of this crisis.

It is imperative, therefore, that the European Central Bank (ECB) does all that it can to prevent this development from becoming a full-blown sovereign debt crisis. It must also ensure that subsequent debt levels do not impede economic activity across the Euro Area in the years to come.

While the ECB is explicitly forbidden from engaging in monetary financing of government debt, there are more imaginative ways it can alleviate the fiscal burden on member states. For example, the ECB could issue very long-dated Eurobonds. It could also loan money to the European Investment Bank which would provide funding to firms in distress.

Overall, it is evident that European institutions must learn from some of the significant policy mistakes which were made in dealing with the financial crisis of 2007/2008. Coordination and coherence are required across institutions such as the European Council (EC), the European Central Bank (ECB), the European Stability Mechanism (ESM) and the European Banking Authority (EBA).